As investors, we need to understand how our companies truly make their money. A neat trick developed for just that purpose -- the DuPont Formula -- can help us do so.
The DuPont Formula can give you a better grasp on exactly where your company is producing its profit, and where it might have a competitive advantage. Named after the company where it was pioneered, the formula breaks down return on equity into three components:
Return on equity = net margin X asset turnover X leverage ratio
What makes each of these components important?
High net margins show that a company can get customers to pay more for its products. Luxury-goods companies provide a great example here.
High asset turnover indicates that a company needs to invest less of its capital, since it uses its assets more efficiently to generate sales. Service industries, for instance, often lack big capital investments.
Finally, the leverage ratio shows how much the company is relying on liabilities to create its profits.
Generally, the higher these numbers, the better. But too much debt can sink a company, so beware of companies with very high leverage ratios.
Let's see what the DuPont Formula can tell us about priceline.com (NAS: PCLN) and a few of its sector and industry peers.
Return on Equity
Expedia (NAS: EXPE)
Orbitz Worldwide (NYS: OWW)
Ctrip.com (NAS: CTRP)
Source: S&P Capital IQ.
priceline.com puts up a very attractive ROE, with a combination of high net margin and high asset turnover without using much leverage. Expedia manages just half the margin and a much lower asset turnover, to turn in an adequate ROE. Ctrip pulls in the best margin here, but its low asset turnover and leverage hurt its return on equity. And Orbitz's high leverage exacerbates the negative net margin, running the return on equity deep into the red.
Using the DuPont formula can often give you some insight into how a company is competing against its peers and what type of strategy it's using to juice return on equity. To find more successful investments, dig deeper than the earnings headlines. And add any of these companies to your watchlist:
Add priceline.com to My Watchlist.
Add Orbitz Worldwide to My Watchlist.
Add Expedia to My Watchlist.
Add Ctrip.com International to My Watchlist.
At the time thisarticle was published Jim Royal, Ph.D.,owns no shares in any company mentioned. The Motley Fool owns shares of Ctrip.com International.Motley Fool newsletter serviceshave recommended buying shares of priceline.com and Ctrip.com International. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.